Everything Buffett Needs to Know, He Learned Right Here

Millions of investors chase Warren Buffett. Tens of thousands attend Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual shareholder meetings. Wealthy fans bid millions of dollars to have lunch with him. His appearances on CNBC bring trading floors to a halt. People want to know what he's thinking. Why he's different. What secret has made him so much more successful than anyone else.

What's interesting -- and a little ironic -- is that Buffett has never held back what his secret is. As he recently told PBS:

I read a book, what is it, almost 60 years ago roughly, called The Intelligent Investor and I really learned all I needed to know about investing from that book, and particular chapters 8 and 20 … I haven't changed anything since.

One book. Two chapters. Legendary success.
You'd think such precisely guided advice would draw more attention. Not only has Buffett filtered his success down to one book, he's even listed the two specific chapters on which he built his wisdom. He's making this almost embarrassingly easy for us.

What bits of sage advice do these two chapters -- published in 1949 by Buffett's early mentor Ben Graham -- hold? Here are key points from each one.

Chapter 8: The Investor and Market Fluctuations
Markets go up. Markets go down. Most of us accept this fact until we experience the latter, at which time we throw up our hands and consider the whole thing a sham.

That kind of behavior is what Chapter 8 is all about: dealing with market movements, and how fundamental they are to investing success.

We have a tendency to become confident and invest the most money after stocks have logged big gains, and vice versa -- selling in panic after big drops. Two seconds of logical thought will tell you this isn't rational. Yet we do it over and over again.

Buffett built his success on exploiting the market's movements, rather than following them with lemming-like obedience. He bought companies like Coca-Cola (NYSE: KO  ) and Wells Fargo (NYSE: WFC  ) when the market wanted nothing to do with them. He then sat on his hands and laughed when companies like Microsoft (Nasdaq: MSFT  ) and Amazon.com (Nasdaq: AMZN  ) soared during the dot-com boom, ignoring heckles about his technophobic incompetence. It's truly as simple as "being greedy when others are fearful, and fearful when others are greedy."

Here's how Graham puts it in Chapter 8:                                                   

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.

Chapter 20: Margin of Safety as the Central Concept of Investment
Graham opens Chapter 20 with a potent message:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass.' Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

We have an overwhelming urge to expect certainty, but live in a world that is anything but. Forward-looking projections of a stock's value are based on assumptions, prone to wild miscalculations and unforeseen events. And by prone, I mean 100% assured.

There's only one surefire solution to this: Pay far less for stocks than your estimate of value, leaving room for error. That's a margin of safety. It's giving yourself room to be wrong, knowing that you probably will be. Think a company is worth $50 a share? Great. Don't pay more than $25 for it. Think a company could earn $2 per share next year? Great. Set yourself up so you'll profit if it only makes a buck. There has to be a wide range of acceptance between the projected and the potential.

One stock that might epitomize the opposite of a margin of safety is Visa (NYSE: V  ) . Visa is a great company, to be sure, exploiting a global consumer shifting from paper to plastic transactions. But it currently trades at more than 22 times 2009 earnings. My calculations of growth show this is probably what the company is worth if everything goes according to plan.

But what if everything doesn't? What if growth hits a speed bump? What if management drops the ball? What if consumer spending takes a sustained nosedive? What if, what if, what if -- that's the basis of a margin of safety. There has to be sizable room for error.

Moving on
These lessons might seem basic and dull. They are. Yet too many investors fail to implement them. Buffett obviously isn't the only one who's read The Intelligent Investor -- he's simply put its lessons and theories to work in a habitual manner.

Our Motley Fool Inside Value team strives to put these basic values to work with all of its recommendations, which are currently outperforming the market by an average of four percentage points each. To see what we're recommending right now, you can try the service free for 30 days. Click here to get started. There's no obligation to subscribe.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Amazon.com and Berkshire Hathaway are Motley Fool Stock Advisor picks. Berkshire Hathaway, Coca-Cola, and Microsoft are Motley Fool Inside Value selections. Coca-Cola is a Motley Fool Income Investor recommendation. The Fool owns shares of Berkshire Hathaway, and has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (174)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 17, 2009, at 2:09 PM, ozzfan1317 wrote:

    I havent had a chance to read this yet but it sounds like sage advice. Rich Dad Poor Dad has some good info though.

  • Report this Comment On July 17, 2009, at 4:17 PM, NotJesseL wrote:

    I am reading this book now, got it on amazon for about $11. I also read Graham and Dodd, which is a real tough slog unless you are really a quant geek. This is much more approachable, and actually kind of fun. One thing that caught my attention was that Graham was a very generous person with his time and money, and really enjoyed life. Do read this book, it will ground a lot of silly bubbles you may otherwise get involved with.

  • Report this Comment On July 17, 2009, at 10:14 PM, orenjikun wrote:

    There is also a section of The Intelligent Investor (and various editions of Securities Analysis) which propose the idea that the more people who use a certain investing technique, the less effective it is. It is subsequently backed up with several examples ("Dogs of the Dow" is one). I believe Buffet has said himself before that he is fortunate that so few people pursue value investing because otherwise it wouldn't work so well.

  • Report this Comment On July 18, 2009, at 1:56 AM, investolator wrote:

    I note that he does not mention "100 to 1 in the Stock Market" by Thomas W. Phelps published in 1972 which introduced the idea of moats, called gates in the book. This book also wrote about holding stocks forever. Let us remember that Buffett is now primarily a growth investor rather than a value investor. Of course he buys growth stocks when they are at a good price. Chapter 24 is "Buy Right and Hold On" in Practice. Here are the first words in chapter 18: "It is one thing to discover that the way to wealth is to buy right and hold on. It is quite another to do it. How does one buy right?".

  • Report this Comment On July 18, 2009, at 5:04 AM, kcaim21 wrote:

    ""Fear when there is greed, and greed when there is fear in the market is simple and yet profound. Most of us know this adage, but it is difficult to attain because it is essentially how to manage our greed and fear by doing the opposite. It is difficult because greed and fear shook us to our core...

    Experiences of greed and fear may be narrated, but the process of experience is very personal and unique to each individual, thus cannot be learned through narration... one just got to go through the process of experience.

    Interestingly the Chinese have specific terms for experience: 经(jīng)验(yàn) and process of experience: 经(jīng)历(lì) Also crisis is 危(wēi)机(jī) and the word机(jī) implies 机(jī)会(huì) opportunity. Hence the saying that in a crisis there is also opportunity.

    Given the unprecedented financial market debacle and early signs of turnaround there are bargains galore... "Inside Value" is a sound way to approach stock pick. Am eyeing when to buy Global Gains China service, just sharing thoughts with fellow Fools... Regards kc

  • Report this Comment On July 18, 2009, at 5:14 AM, kcaim21 wrote:

    NotJessel: Thanks for the intro review of the book The Intelligent Investor, will look it up at Amazon...thanks much.

    Regards

    kc

  • Report this Comment On July 19, 2009, at 3:17 PM, mhoff149 wrote:

    You can probably get The Intelligent Invester at your local library, I did.

  • Report this Comment On July 19, 2009, at 6:29 PM, PSU69 wrote:

    Read Snowball, the latest book about the sage from Omaha. His life is a very interesting collection of work and personal focus (plus some really ODD behavior). He has won many hearts and he has earned a ton by being his own dog.

  • Report this Comment On July 20, 2009, at 2:03 AM, kcaim21 wrote:

    Hi mhoff149: thanks for the kind thought about borrowing from library. i am miles from home singaporean based in Beijing.

    Read One Up on Wall Street- Peter Lynch 11 times, last year... Retired from financial sector since mid 2002... promised myself to abstained from financial market for at least 5 years and didn't "sense right timing" waited for another one and a half year. Got back into the market Jan~Mar 2009 some stock picks down 30~40%, and some up by 100~200%, on balance up by about 30%...also keeping myself busy learning Chinese and speaking Mandarin... and trying to learn LaoZi classic: the way and virtue.

    Thanks again, i must read The Intelligent Investor...hopefully i don't make too many new mistakes after x times reading.

    Enjoy whatever you do...regards kc

  • Report this Comment On July 21, 2009, at 2:06 PM, Gregeph wrote:

    Great points from The Intelligent Investor. Investing is simple, but it is not easy. Buffett spends, by his own account, 60 hours per week reading and thinking about investments. Making your own investments requires work. If you don't do the work and if you don't understand the company, you are speculating.

    http://valueinvestingfundamentals.blogspot.com/

  • Report this Comment On July 24, 2009, at 5:25 PM, malinbeg wrote:

    The Intelligent Investor should be required reading for all potential and existing investors. Nothing will ever beat simple logic.

  • Report this Comment On July 24, 2009, at 6:44 PM, 1986alisha wrote:

    I read Ben Graham's book many years ago, but somehow I didn't learn what Buffett did. My bad.

  • Report this Comment On July 25, 2009, at 12:32 AM, Goldtea wrote:

    "Whatever go up will come down.Pick when nobdoy is around.". This rule is know to everyone.. The challenge is how to overcome your fear when we are around the bottom of teh market and not to get too excited when market is zooming for the top. I see PE rating for stock trade at 100 multiple when the market is booming and down to 2 when the market crasp. This is speculative stock. Today, a lot of people are buying stock with speculator menatlity, not as a investor. They want to be millionair within a short time frame. Easy come easy go.. We needs to built of accumulation mentality. Not to chase the market not move away from the market , when it down. Be a Zen investor wtch the market dance..

  • Report this Comment On July 25, 2009, at 7:20 AM, joaquingrech wrote:

    Just a small note. There are a few editions of the book so I went to check which one Buffett was referring to.

    If you have the original 1949 edition, the chapters are 2 and 16 (second and last). There is no such thing as chapter 20.

    If you have the revised editions, then you have them on the correct order. Just make sure to check the titles and not the numbers.

    I have the original edition for nostalgic reasons. You can find both on Amazon.

    Joaquin Grech

  • Report this Comment On July 27, 2009, at 9:41 AM, howboutme wrote:

    I have not read the book but in just reading the article and commentaries it all sounds a lot like timing the market.....buy low sell high. For the minimal ($ amount) investor this doesn't do much for bringing in good profits...even if it is a ten year span. The other issue is what to buy when the market bottoms. Recently no one could do that because you didn't know which company would fold. IT is a little easier to make a bundle when you can risk a bundle in the first place. That is the advantage that Buffet had from the get go.

  • Report this Comment On July 27, 2009, at 7:32 PM, nivekluap wrote:

    I've been reading quite a bit for almost two years now and have held individual stocks for about a year. The more I read, the more fascinated I become with the whole investing world. Not quite done with "The Intelligent Investor" yet, but it should be required reading for anyone thinking about investing in anything but a savings account at the bank.

    Mr. Buffett has two qualities that has made him wealthy: Hard work and a calculating mind that doesn't quit.....and patience, and charisma...wait, that's 4...:-)

    I enjoy reading these comments below the articles as well as the articles themselves. It's the most fun when people are writing as though the world is coming to an end because Mr. Market tells them their business is worth 5% less today than yesterday just because it sprinkled outside instead of being sunny like the weatherman said it should. Build in a margin of safety, check on the business on a regular basis, and sell whenever you want to.

    Thanks to all who posted their comments here and in Fooldom in general...it's entertaining and enlightening.

    K.D.

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